The past few years have seen an explosion of interest in dividend investing. While there are (arguably) good reasons for this, many investors don’t seem to fully understand what dividend payments actually represent.
I thus thought it might be worth shedding some light on the subject. Note that my goal here is not to debate the merits of dividend investing, but rather to discuss where dividend payments come from and to point out why one of the most common arguments in favor of this strategy is misleading.
What is dividend investing?
For starters, what exactly is dividend investing? In short — and yes, I’m oversimplifying things a bit — it’s an investment strategy that involves building a portfolio consisting of companies with high dividend yields.
Why? Well, as noted above, there are a number of reasons for doing this. But one of the most frequent arguments in favor of dividend investing goes something like this:
Did you know that reinvested dividends accounted from XX% of the <whatever index’s> return from 19YY to 20ZZ?
You can fill in the blanks, but it’s usually a fairly large percentage of the returns of a well known index over a relatively long time period. Sounds compelling, doesn’t it?
Unfortunately, even if the numbers are accurate, such arguments can be rather misleading. Want to know why? Then please keep reading.
What are dividends?
Wikipedia defines dividends as follows:
A dividend is a payment made by a corporation to its shareholders, usually as a distribution of profits.
While dividends can technically be in the form of cash, stock, or property, the most common case is cash distributions — so that’s what we’ll focus on.
To pay or not to pay?
When a company makes a profit, it has a choice: reinvest that money in the underlying business or distribute it to shareholders. I guess they could also just hoard the cash, but we’ll ignore that possibility for now.
When they choose to pay a dividend, they reduce the amount of cash that the company has on hand. Thus, they reduce the inherent value of the company, and this is reflected in a proportional reduction in share value.
In other words, dividend payments are not free money. Rather, they represent a cashed out slice of the company’s value. And it should thus come as no surprise that it’s important to reinvest if you want your investment to grow.
Apples and oranges
This is not the same thing as saying that investments in companies that pay dividends will grow XX% faster than investments in companies that do not. But that’s what the argument highlighted above seems to imply.
With dividend payers, you’re getting a portion of your returns as cash — at the cost of a small hit to the underlying share value whenever these payments are made.
On the flip side, when a company chooses to reinvest in their operations, they are doing so with the expectation that they will be able to grow the business, and thus increase shareholder value. So they’re effectively doing the reinvesting for you.
In essence, failing to reinvest your dividends is akin to selling off a small portion of your holdings in a non-dividend payer and using the money for something else. We’re really talking about two sides of the same coin here.
The bottom line
In my view, what investors should really care about is the total return of their investments. That is, the growth in share value plus any dividends that are paid out (and, ideally, reinvested). How you get there is less important.